The BRICs have fallen

In five years’ time, the stock exchange winners will be found in emerging markets, writes Kristoffer Stensrud. Photo: Bloomberg.

Fourteen years ago, shortly after the fatal terrorist attacks in New York, I wrote that China was going to be of great significance for world economic growth going forward. So-called economic experts practically sneered and said that China's economy would only have minimal influence as it was after all barely larger than that of Italy.

Expectations of strong growth in the Chinese economy, and a world economy that had bottomed out, formed the seed that turned into our idea to start a pure emerging markets fund. Equities in this part of the world had remained depressed ever since the emerging markets bubble burst in 1994. At that time, the pricing of companies had been boosted by speculation based on the billions of people living in that part of the world. Value creation in the companies was nothing to brag about, however, and the pricing was far too high. Things had to go wrong.

After 9/11, the aggressive head of the US central bank, with his interest rate gun full of dry gunpowder, kick-started what would go on to become a historic rally for emerging markets. Both for the real economy and the stock markets.

Communist China commanded farmers to lay down their picks and shovels and take their place on assembly lines in factories that would produce cheap goods for the entire world. At the same time, China became a member of the World Trade Organisation and an integrated part of the global economic system.

We saw the first signs of the coming upturn at the end of 2001, via the classic economic indicators such as higher copper prices and dry bulk rates at sea. The timing seemed to be perfect to launch an emerging markets fund. As we got started in April 2002, however, we were (indirectly) hit by the two accounting scandals in the US, namely Enron and Worldcom. The fund fell by over 40 percent in just a few months!

Nonetheless, an active value based investment philosophy, which bought what China bought and stayed away from what China sold, subsequently led to a fantastic rally. Those who instead opted for overpriced US companies experienced a decade without returns. Although the stock prices did not rise, the large US companies continued to earn good money. The problem was that the companies were far too high priced relative to earnings.

In recent years the picture has been turned on its head. Investors in emerging markets have experienced a fairly lamentable return, while those who have invested in US stocks have once again been the winners. While emerging markets have for too long lived off old (Chinese) success, the financial crisis prompted the US to take a hard grip on the cost and restructuring knife. Several US manufacturing companies can now compete with the Chinese on wages and other costs and profit margins are hitting record highs. However, the pricing of the companies' earnings are also reaching record levels.

Many years of overinvestment have led to falling capital returns in global emerging markets. Not even weakening exchange rates since 2013 have yielded results. The time is more than ripe for the companies to take responsibility for their own development, adapting capital usage and costs to the new reality. Just as the Norwegian oil industry is about to do.

Last decade's growth engine – the BRIC countries – is a central force slowing down emerging markets. Brazil is hampered by commodity and corruption withdrawal. Putin may still be showing muscle, but it is not financial. India is about to come out of the democracy and bureaucracy closet, but so far it has mostly just been big words and expectations. India's aim to take over China's role as the world's factory, and turn "Made in China" to "Made in India" is uncertain, but not unattainable in the long term. China's transition from an investment and export-based economy to a service and consumer-driven one is proving painful, both locally and globally.

Is it then foolish to continue to sit and wait for better times in emerging markets? We cannot emphasise the point enough: There is a difference between real economic development and which way share prices head. Not to mention the fact that equity prices fluctuate much more than the underlying value development.

The world is global, with no natural distinction between emerging and developed markets. The companies, on the other hand, have the whole world as their playground and that will be key in future. In a climate in which raw material and energy prices are falling, some countries will be winners and other losers. Most importantly, however, within each sector only one or a handful of companies will be winners. These are the companies we try to find, but without paying so much that it is at the expense of return on capital.

Now that price tags are down to financial crisis levels, we dare to predict that the winners five years ahead in time are now to be found on stock exchanges in emerging markets.